Apple: iTunes and Apps To Make Up 20% of Profit by 2020, Says Macquarie

By Tiernan Ray

Shares of Apple (AAPL) today are up $2.30, or 0.4%, at $531, after Macquarie Equities Research USA’s Ben Schachter initiated coverage of the stock with an Outperform rating, and a $630 price target, writing that the value of iTunes and Apple’s other software and services is under-appreciated.

However, we believe that its iTunes/Software/Services business have not been a key focus for many investors. We expect that to change over the coming years, as these ultra- high-margin businesses will likely be a key profit driver for AAPL, particularly its app sales. Its iTunes/Software/Services gross sales should grow from ~$23b in FY’13 to ~$70b by 2020, and by then could comprise almost 40% of operating profits (while still just north of 15% of sales).

With margins of 90% or more, revenue from iTunes, including sales of apps and other components, which was $16.05 billion in fiscal 2013, made up 18% of Apple’s revenue, he estimates, while being only 9% of total company revenue.

The result is that “By 2020, iTunes/Apps should be ~20% of total company EBIT, almost triple its current levels. Notably, this could prove conservative if the iTunes non-App content segment reaccelerates. Despite our expectations for music to continue to be a headwind, new innovations around Apple TV and a potential Apple television could help drive more iTunes non-App content.

Here’s Schachter’s model for how that can evolve (click for larger image):

Schachter points out that software and services is composed of different forms of revenue recognition:

The second point to understand about this line item is the revenue recognition and accounting treatment regarding agency vs. wholesale pricing. Under the agency model, the content creator/publisher sets the price and AAPL would recognize the net revenue. Under the wholesale model, the distributor (AAPL) sets the price and would recognize the gross revenue. For example, in the agency model, an app developer sells a game through the App Store for $10. Because the app developer set the price, Apple would only recognize $3 (30% of $10). In the wholesale model, a music publisher sells a song to AAPL and then AAPL sets the price at $.99 on iTunes. AAPL would book the gross sale of $0.99.

In any event, it’s highly profitable revenue, he writes:

On a net revenue basis, we believe that this is a very high-margin revenue stream. The key costs of the net revenue associated with iTunes/App Store are credit card fees (~1.5%-2.5%), streaming fees, R&D, datacenter depreciation, some small % of costs associated with retail locations, gift card sales, etc… The Other SW/Services line includes AppleCare costs, partially offset by Google search distribution revenue and other very high-margin revenue. Overall, we believe that on a net revenue basis (after paying content costs), the iTunes/Software/Services line item has 90%+ gross margins and ~80%+ operating margins. Thus, these businesses are punching far above their weight in terms of profit contribution, particularly Apps (which are driving the vast majority of the growth).

To be clear, Schachter notes most of that revenue is content on iTunes — apps, music, etc. — not actual software sales, and in particular app sales. Here’s how he plots the composition of revenue:

Despite the fact Google (GOOG) has been gaining on Apple’s app sales with its Google Play store, Schachter sees further upside if Apple can expand the kinds of content and services it provides:

Expansion into new product categories has the potential to provide upside to current estimates and boost revenue growth rates. Apple has announced or is reported in the press to be developing products in a number of new areas that could eventually become meaningful contributors to the company: CarPlay: Apple has recently announced this product, which features integration between the iPhone and the in-dash information/entertainment system in a car. CarPlay allows hands-free use of calling, messaging, navigation and music player on the iPhone while driving (addressing safety concerns related to mobile phone usage in the car). This will not necessarily be a direct revenue generator for AAPL, but it follows Google’s long-time model of encouraging the usage of the company’s portfolio of services more frequently and in more places, which should drive incremental revenue for Apple. Apple TV 2.0 / Apple television: While this has not been officially announced (but has been widely discussed in the press), we expect to see an updated version of Apple TV launched shortly, with expanded streaming and gaming functionality (including the potential for a dedicated Apple TV App Store). The potential for TV-centric Apps could be underestimated in our model. Depending on execution, we think Apple could see TV-centric apps and content ramp quickly. Additionally, we also see potential for a “next-gen” Apple television, incorporating the iOS software/user interface directly into a high-def television display. Numerous reports have suggested that such a product is in development, but its ultimate fate remains decidedly unclear (and our colleagues in Asia are skeptical about this product). iWatch/Wearables: Also not yet officially announced, but Apple has been widely reported as testing and developing a smart watch based on iOS, which tethers with a user’s other iOS devices. The potential for this device remains unclear, as Samsung has received a lukewarm consumer response to the first generation of its Galaxy Gear smartwatch, but if Apple can get the hardware right (specifically regarding the battery-life issues which have troubled Samsung’s initial design) and demonstrate meaningful use cases (most likely around communication, health, and fitness monitoring), an Apple-designed smartwatch could eventually become a meaningful contributor. Payments: Mobile payments is a highly fragmented industry at a very early stage of evolution. Given Apple’s position in mobile with the iOS ecosystem, it is in a favorable position to potentially enter the market in a somewhat unique position. While it already has its Passbook feature in the market, this is just an intermediate step. We believe that the company could make a more substantial play in the space in the coming year. Home Automation: This also represents a nascent market with much potential for growth over time. While not likely to be a NT driver, we think there is great opportunity for AAPL to launch well-designed home automation products that would tie into the iOS ecosystem. We envision these products focusing on energy, healthcare/fitness, security/monitoring, entertainment, etc… Exclusive Media Content: We believe that Apple would benefit from the deployment of some of its considerable cash balance toward securing exclusive media content. In our 15 years of covering the interactive entertainment space, we have frequently observed the value that can be generated through high-quality, desirable content that is exclusive to a platform (the original Xbox is a classic example of this, with early-stage growth driven in large part by the popularity of Halo). We think just one or two key exclusives could be very helpful in establishing new products and extending iOS’s reach.

As for hardware sales, Schachter is more guarded:

While we are cautious around projecting growth for AAPL’s current hardware lines, we do expect significant innovation and potentially new product categories to come from AAPL. And while we are bullish on their potential, we believe that quantifying expectations without more knowledge does not add to investors’ understanding of the stock. Therefore, our current model does not explicitly include any revenue from potential future products such as wearables, payments, television or others […] Macquarie has 31 TMT senior research analysts globally, including 22 in Asia. We will leverage these assets to provide insights and data points when appropriate. Currently, our Asia team believes that a new iPhone with a 4.7” screen as well as semiconductor-related specs such as 64-bit application processor, fingerprint ID and additional sensors (per the MacqTech Thematic – Three emerging semi trends, published by Jeff Su and our Asia tech team) should drive a robust bottom-up product cycle, and is coming around September. As stated above, we look for iPhone growth of ~7% in FY’14 and 9% in FY’15 based likely on upgrades to a larger screen size. Additionally, we expect limited growth in iPads in FY’14. We don’t expect a meaningful iPad mini refresh this year, nor do we expect a larger enterprise-sized iPad until next year. We do expect a September quarter refresh for iPad Air.

About Tech Trader Daily

Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.